Inflation. What Inflation?

Reversion to the mean is one of finance’s most tried and true principles. As financial professionals, any time we see an asset class rise to an unsustainable valuation, or a statistical data point reach a level it never has before, we start with the premise it will eventually return to the long-term average.

What if tried and true principles aren’t so true though?

Current Inflation Environment

Average inflation for the last 50 years, as measured by the CPI-U on a quarterly basis, has been 4.1%. However, the last time measured inflation was above this number was September 2008. The U.S. has gone almost a full decade without an inflation reading higher than the 50-year average.

The forward projections don’t improve this picture. As of October 18, 2017, close, the 5-year breakeven rate (a measure of the market’s expectation for future inflation) was 1.75%. The 10-year breakeven rate was a paltry 1.84%. Therefore, assuming the market’s anticipation is correct, the U.S. may go a full two decades without ever reaching the 50-year average inflation.

Last month, Fed Chair Janet Yellen said, “The shortfall in inflation is a mystery,” during a speech in Ohio. As portfolio managers, it should grab our attention when the captain of the government’s $4 trillion economic stimulus ship is saying she is adding extra sail and the ship is not going faster. It should be even more attention grabbing when she says she doesn’t know why the ship isn’t going faster.

Why is the economy maintaining historically low inflation numbers?

Forces Helping to Keep Inflation Low

If you were to do a simple internet search for low inflation, you will see a multitude of articles written that identify several reasons why inflation has been low. For this article, there are five forces to be discussed:

1. Technological innovation

2. Global Trade

3. Consumer Debt/Student Loan Debt

4. Demographics

5. Lack of Effectiveness of Quantitative easing (QE)

Technological Innovation

Look no further than the pocket of your pants to see how technological innovation has impacted inflation. In a June CNBC article, BlackRock’s CIO cited, “An iPhone in 1991 storage and computing cost dollars would be worth $1.44 million per phone.” Given that anyone can go to an Apple Store today and purchase an iPhone 8 for $700, you can see the impact that innovation has on inflation rates. Likewise, given Moore’s Law, it is safe to believe this impact will be felt into the future.

Technology’s impact on inflation extends beyond just computers and phones though; just look at the innovation within oil fracking. According to the Energy Information Administration, at the end of 2015 there were 300,000 fracking wells compared to just 23,000 at the end of 2000. The biggest difference comes in terms of output though. While there are 13x more wells, the output has increased 42x from 102,000 barrels per day to 4.3 million during the same time periods. This increase in output is reflective of the technology innovation in fracking. The impact of this has been a cap on the growth in the price of oil, and possibly even a deflationary pressure. For the last two years, oil has traded between $33 and $54 per barrel – compared to an average of $75 since the equity market recovery began.

Global Trade

Over the last 20 years, many barriers to global trade have been broken down. While governments have largely helped to increase global trade, market forces have had a profound impact as well. The rise of internet commerce and global logistics have forever shaped the purchase of many goods. Amazon’s recent purchase of Whole Foods is a domestic example of how efficient logistics are shaping even food delivery domestically.

How can the price of goods go up in the U.S. when global suppliers are willing to provide lower cost goods directly to consumers? For some goods, the answer is, “they can’t.”

Consumer Debt/Student Loan Debt

In 2016, CollegeBoard published a study entitled, “Trends in Student Aid 2016.” Within the study, they showed how student loan debt, both federal and nonfederal loans, grew from $42.6B in the 1995-1996 school year to a peak of $124.2B in 2010-2011 (both in 2015 dollars). Granted, enrollment in higher education also increased during this time but did not keep pace with the 200%+ increase in loan debt.

While student loan debt has been increasing, consumer debt service has been fluctuating. For the first half of the past decade, consumer debt payments as a percentage of disposable personal income declined from 5.9% to 4.9%. However, since the deleveraging ended in 2012, this ratio has been increasing and is now slightly above 5.6%.

Debt essentially trades future spending for spending today. The growth in student loan debt, and the growing consumer debt service ratio, seem likely to be negative forces to future inflation rates. Dollars that could be going to stimulate the economy through purchase of goods and services are instead going to service debt which has accumulated.

Demographics

According to the Pew Research Center, the Baby Boomer generation was surpassed in 2015 by the Millennials for the largest generation in history. However, Baby Boomers still number almost 75 million in population. The heart of this generation, currently ages 53-71, is right at retirement age. As people age, they tend to spend less money overall. The Bureau of Labor Statistics show that persons age 55 and older spend 10% less than the population. In addition, people 75+ spend 30% less than the population. It is reasonable to expect the ageing of the second largest generating in history to hold down future inflation given they will consume less each year.

Lack of Effectiveness of Quantitative easing (QE)

The success of QE is perfect fodder for political dichotomy. Those who believe in big government will credit QE as an example of the government and its band of superheroes saving the world. Those who believe in free markets will claim QE had a negligible impact, as most of the cash created has simply moved from Fed servers to the servers of large banks. Complicating this equation is the indirect psychological impact of QE, which is hard to measure.

While we tend to side with those who feel QE fell short, no one can know for sure. Taking in all the research, our most profound feeling is we discount the amount of pent-up inflation that may exist. The Fed has created a sentiment that it has pumped amazing amounts of helium into the balloon and that the balloon should rise at some point. However, we believe that much of the helium didn’t make it into the balloon—and the balloon has more than one chamber. Therefore, it is not a given that inflation will spike quickly at some near point simply from aftershocks of QE.

Is there Hope for Future Inflation?

With every financial topic, there are always investors taking opposite sides. There is certainly hope for those who believe future inflation will be higher.

First, the dollar has been on a torrid pace of strengthening since 2011 through the end of last year. If this trend goes back to the mean and the dollar significantly weakens, inflation could pick up as commodity and energy prices increase. We saw a hard weakening in the Pound Sterling have inflationary pressure in the U.K recently, for example.

In addition, if the private sector decides to continue leveraging, future spending could happen sooner and result in short-term inflation increases. As stated earlier, this is likely to be a negative for longer trends but increased borrowing now also leads to increased consumption. Tying into this would also be wage growth. If the economy sees significant wage growth, price inflation would seemingly increase assuming two things: the personal savings rate did not increase substantially and the consumer does not decide to use the wage growth to continue paying off debt.

Lastly, and maybe more likely given the recent saber rattling, military war could increase inflation. War times can certainly cause price inflation for the consumer and result in upticks to longer term inflation.

Investing with Inflation

Given the forward breakeven rates, one might think that buying Treasury Inflation Protected Securities (TIPS) may not make a lot of sense. However, given the 5-year inflation breakeven rate is just 1.75%, an investor is not giving up substantial yield to insure against inflation risk.

The ETF industry has provided a plethora of options to investors to gain exposure to TIP bonds. The largest of these is the iShares TIPS Bond ETF (TIP) with over $25B of assets. In addition, there are some unique holdings like FlexShares iBoxx® 3-Year Target Duration TIPS Index Fund (TDTT) and FlexShares iBoxx® 5-Year Target Duration TIPS Index Fund (TDTF) which target 3-year and 5-year durations respectively. There are also funds which own just the short end of the TIP curve without targeting specific durations like Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) and PIMCO 1-5 Year U.S. TIPS Index Exchange-Traded Fund (STPZ).

Summary

There are many factors which appear to be opposing the tried and true reversion to the mean investment principle when it comes to future inflation. No one knows for certain what the future inflation rate will be. What we do know is that the cost, in terms of yield, to insure against higher inflation is historically low. Given this, and the potential for other factors to push inflation higher in spite of opposing forces, it may make sense for an investor to position a portion of their portfolio in TIPs

This article was written by Tyler Denholm, CFA – VP Investment Management & Research at TOPS ETF Portfolios, a participant in the ETF Strategist Channel.

Disclosure Information

TIP, TDTT, TDTF, VTIP and STPZ have been, may be and/or are currently held in several TOPS portfolios.

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